Tax Ninja: Slashing Your Tax Bill with Smart Income Strategies for a Wealthier Future

There are few things more exciting than seeing your wealth grow over time, but as your income evolves, so do your tax responsibilities. Understanding the various types of income and how they’re taxed can mean the difference between watching your hard-earned money slip away or keeping more of it to reinvest and build your future. The tax code might seem complex, but once you understand the landscape, you’ll find there are ways to make savvy moves that can minimize your tax bill.

We’re going to break down the three main types of income—ordinary, portfolio, and passive, and – and highlight why their different tax treatments are so important. We’ll then apply this to an actual real life example and explore how a married couple, early in their career and later in retirement, can use tax-smart strategies to maximize wealth accumulation and minimize taxes throughout their lives.?

Understanding Various Types of Income

To start, let’s define the key terms so you can see how each type of income plays a role in your financial strategy.

1. Ordinary Income

This is the most straightforward type of income—it includes wages, salaries, bonuses, tips, and income from self-employment. Ordinary income is taxed at the federal government’s progressive income tax rates, ranging from 10% to 37% depending on your total taxable income. You’ll also be subject to Social Security and Medicare taxes on earned income. Depending on your state of residence, you may also be subject to to state and local income taxes.?

2. Portfolio Income

Portfolio income is generated from interest, dividends, and capital gains from investments. Unlike ordinary income, portfolio income is often taxed at lower rates. Qualified dividends and long-term capital gains (for assets held over a year) enjoy favorable tax rates of 0%, 15%, or 20%, depending on your taxable income.

3. Passive Income

Passive income typically comes from rental properties, limited partnerships, or other business ventures in which you’re not actively involved. Passive income is usually taxed as ordinary income, but it has some additional quirks. For instance, passive losses can often only offset passive income, not your ordinary wages, unless you’re a real estate professional or meet other specific criteria.

A Tax-Savvy Married Couple’s Journey

Now that we’ve outlined the types of income and how they’re taxed, let’s explore how a hypothetical married couple, Paul and Hannah, could make savvy tax moves throughout their lives—from early wealth accumulation to a successful, tax-efficient retirement.

Early Years: Accumulating Wealth While Minimizing Taxes

Paul & Hannah are in their late 20s, both working full-time jobs and bringing in a combined salary of $150,000. They know their ordinary income is taxed at federal rates up to 22%, so they decide to make some strategic moves to minimize their taxes while building wealth.

1. Maxing Out Tax-Deferred Accounts The couple contributes the maximum to their employer-sponsored 401(k) plans—$22,500 each in 2024. This not only helps them save for retirement but also reduces their taxable income by $45,000, lowering their federal tax bracket.
2. Opening a Taxable Brokerage Account In addition to their 401(k)s, Paul & Hannah open a taxable brokerage account. Here, they invest in a mix of index funds and dividend-paying stocks. By focusing on tax-efficient investments (like ETFs and qualified dividend-paying stocks), they limit the amount of taxable portfolio income during their high-earning years. Even when they eventually realize capital gains, they know that long-term capital gains (from investments held over a year) will be taxed at a lower rate than their wages.
3. Harvesting Capital Losses During a market downturn, Paul & Hannah engage in tax-loss harvesting. This strategy allows them to sell underperforming investments to realize losses, which they can then use to offset gains elsewhere in their portfolio. They’re able to deduct up to $3,000 of capital losses from their ordinary income annually, and any excess losses can be carried forward to future years.

Middle Career: Growing Wealth and Strategic Reinvestment

By their 40s, Paul & Hannah have climbed the career ladder and now earn a combined $250,000 annually. Their goal is to maximize tax efficiency while continuing to build their investment portfolio.

1. Backdoor Roth IRA Contributions Because they’ve exceeded the income limits for direct Roth IRA contributions, they use a backdoor Roth IRA strategy. By contributing to a non-deductible traditional IRA and then immediately converting it to a Roth IRA, they can take advantage of tax-free growth on their investments for the rest of their lives.
2. Shifting Toward Tax-Efficient Investments In their taxable brokerage account, Paul & Hannah begin shifting more of their portfolio into low-turnover index funds and municipal bonds, which generate tax-exempt interest. This minimizes their taxable income while still allowing their wealth to grow.
3. Using Capital Gains Strategically As their taxable brokerage account grows, they continue to hold most investments for the long term, so when they need to sell assets, they qualify for the long-term capital gains tax rate. They also plan to strategically sell investments in years when their income might be lower (due to job changes or taking time off), so they can take advantage of the 0% capital gains tax rate.

Retirement: Smart Drawdown Strategies to Minimize Taxes

Fast forward to their 60s, Paul & Hannah have built a significant nest egg, with a mix of tax-deferred retirement accounts, taxable brokerage accounts, and Roth IRAs. Now, the focus shifts to minimizing taxes in retirement, particularly in their early retirement years before required minimum distributions (RMDs) kick in at age 73.

1. Drawing from the Taxable Brokerage Account First In the first years of retirement, Paul & Hannah draw down from their taxable brokerage account, particularly focusing on long-term capital gains. Their taxable income, now much lower than during their working years, allows them to stay within the 0% capital gains tax bracket. This move effectively gives them tax-free access to their investment gains.
2. Roth IRA Conversions To avoid getting hit with large tax bills when RMDs begin, Paul & Hannah start doing partial Roth conversions. Each year, they convert a portion of their tax-deferred 401(k) and IRA assets into Roth IRAs. They carefully plan these conversions to keep their taxable income below certain thresholds, maximizing their 12% ordinary income tax bracket and avoiding higher rates down the road.
3. Tax-Efficient Social Security Timing Paul & Hannah also delay claiming Social Security until age 70 to maximize their benefits. In the meantime, they rely on their taxable brokerage account and Roth IRAs for income, keeping their taxable income low. When they eventually start receiving Social Security, the majority of it remains tax-free due to their low taxable income.

The Power of a Taxable Brokerage Account and the 0% Capital Gains Rate

The taxable brokerage account plays a crucial role in people’s financial success, but I often that people ignore this type of account either because of the confusing use of the word “taxable” in the title or just because they don’t think about it. However, it provides a massive amount of flexibility in retirement, allowing them to access funds without triggering high tax rates, and the favorable long-term capital gains tax rates make it even more attractive.

By managing their taxable income carefully and strategically selling investments at the right time, they qualify for the 0% long-term capital gains rate for married couples. For example, in a year when their taxable income is below the $89,250 threshold, they could sell $50,000 worth of investments and pay no capital gains taxes on that amount. This is one of the biggest tax advantages available to retirees with taxable investments.

Conclusion: Build Tax-Savvy Strategies Now, Reap the Rewards Later

Paul & Hannah’s journey shows the power of understanding how different types of income are taxed and making tax-smart moves throughout your career and into retirement. By being strategic with their tax-advantaged accounts, leveraging taxable brokerage accounts, and taking advantage of favorable capital gains rates, they build wealth efficiently and pay less in taxes over the long term.

Whether you’re just starting your career or planning for retirement, these strategies can help you keep more of your hard-earned money and set you up for financial success. The tax code might seem intimidating, but by understanding how different types of income are treated and implementing the right strategies, you’ll be well on your way to a financially secure and tax-efficient future.

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The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.

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